Wednesday, January 21, 2015

Why the ECB Should Take More Risks

Mrs. Merkel and Mr. Schäuble are worried. The ECB is planning to buy the sovereign debt of its member states and Mr. Schäuble doesn't trust his southern European partners. He thinks that Portuguese, Spanish and Italian debt is risky and he knows that Greek debt is.

Bankers are supposed to be boring. And central bankers are supposed to be boring in spades. What would happen if the Fed were to bet the farm, buying shares in an internet start-up that subsequently goes bust? The public purse would be on the hook for the loss. At least, that’s the theory. That theory is wrong.The central banking business plan is a money-spinner beyond a venture capitalist’s wildest dream. Buy an asset, any asset, and pay for it by issuing little pieces of colored paper. Collect the interest payments and dividends from the assets and use them to pay for your house, your car and a holiday in Spain. If you happen to be the central bank of a sovereign state, pay the interest and dividends to the treasury to help reduce the tax bill of your citizens.

Does it matter which assets you buy? Conventional wisdom says yes. A central bank should buy safe assets, typically promises issued by its own national government that will never fall in value. The Fed buys T-bills on the private market. The Treasury pays the interest and principal to the Fed, and the Fed turns around and pays them straight back to the Treasury. The point of all of this is to keep enough of the little pieces of colored paper passing from one person to another to “oil the wheels of trade”.What if the Federal Open Market Committee were to put all of the Fed’s assets into the stock market the day before a stock market crash? If the Fed were privately owned, it would be put into receivership. After the crash, it has liabilities of $2,500b. These are the circulating pieces of colored paper. But its asset portfolio has been decimated by the market crash and the market value of those shares has fallen from $2,500b to $1,000b. What a calamity! Surely the taxpayer must rush in and recapitalize the Bank by pumping in another $1,500b. Not so.

Central banks, like the rich, "are different from you and me". Their debts are all in the form of those little pieces of colored paper. And the magic of central banking is that you and I will carry on passing those pieces of paper from one to another without ever trying to cash them in for something else. There was a time when the UK government printed the promise to “pay the bearer on demand, the sum of one pound” on its notes; at the time, a pound note was redeemable in gold. That time is long gone. All you will get at the Bank of England now, if you try to redeem your ten pound note, is two fives.What does all of this have to do with the ECB? Mrs. Merkel and Mr. Schäuble should sleep easily in their beds. The interest payments on ECB assets are returned to national governments in proportion to a formula that weights each country by its relative size. As Paul DeGrauwe pointed out recently in a VoxEU post, as long as the ECB sticks to this formula when it buys sovereign debt, the only people to suffer from an Italian default will be private holders of Italian bonds. The net worth of the ECB may take a temporary hit, but that shouldn't bother European taxpayers, least of all the Germans.Extraordinary times require extraordinary measures. There was a time when central banks were privately owned. The Swiss National Bank still is. But the Bank of England, the Federal Reserve and the European Central Bank are supra-national institutions that play by different rules. We should not be concerned if sovereign states are permanently in debt. This has been the case with the UK and the US treasuries for as long as the US and the UK have existed as sovereign nations. What is true for a national treasury, is also true for a central bank.

"From an accounting standpoint, the loss should be recognized appropriately and the balance sheet recapitalized with newly issued bonds. That is the correct way to recognize and crystalize a loss on the ECB balance sheet. De Grauwe instead treats an actual loss as if it were a forgivable opportunity cost that can simply be swept under the rug of future seigniorage. The proposed treatment plays fast and loose with regular accounting, committing errors of economic analysis in the process."

I don't see that at all. Your argument assumes that there is a meaningful concept of the net worth of a central bank. There is no reason why the net worth of the central bank should be positive. A central bank that issues fiat money is in effect, its own sovereign. There are many potential exit strategies from QE including, for example, raising reserve requirements. I'm with DeGrauwe on this.

Well, that’s one paragraph. The argument is the whole post, and concerns a lot more than that point. In fact, the argument is independent of that point, which is procedural and best practices (in my view), and whether or not I assume it, it actually doesn’t matter to the analysis of the real fiscal costs I have pointed out. So any concern about it is largely a red herring.

But I certainly do believe that the net worth of a central bank is a meaningful concept in the following sense. I believe it is meaningful for either a positive or a negative net worth - because the capital position is an accounting entry that along with distributions represents the cumulative impact of monetary operations. It is part of the way of keeping track of what has happened, and it is useful and quite meaningful to keep track of what has happened. Apart from that, I’m quite aware that a central bank’s liquidity powers are dominant in a way in which they are not for the private sector, and that a central bank can eliminate a negative capital position over time through seigniorage.

So that’s not the same thing as insisting that the net worth of a central bank must be positive at all times. I haven’t said that.

What I said was that recapitalization is the correct way to crystallize a loss. And crystallization of losses becomes much more critical when allocating out profits from a multi-sovereign central bank in a currency union. That’s how you get accountability tracking by sovereign. That’s the main point of the post. Tracking the losses is an issue in this case in a way that it is not so much an issue in the single sovereign case. The attitude can be much more relaxed in theory I think in the case of the SNB for example (relatively speaking) or the Fed.

In any event, I agree it’s not absolutely essential to the economics. But the aspect of recapitalization versus negative equity is really secondary or even tertiary to the two primary analytical concerns I’ve highlighted in the post. In other words, whether or not capital is run negative is not my main concern. I’ve just suggested that recapitalization is advisable in this case because the fiscal consequences are very real and should be tracked in a disciplined way – as they are distributed out to sovereigns that don’t have control over their super-central bank. And they should be tracked with some rigor and not forgotten about. I think recapitalization – instead of negative equity – would be a catalyst for not forgetting that these would be real losses.

OK. But I still don't see there why there are any "real losses". One could imagine the creation of a newly created central bank of a monetary union that prints bank notes and gives them as transfers to its citizens. That bank would never engage in any operation in which it lends to anyone, including the treasuries of its constituent member states. Who is losing here and why? What are these real fiscal consequences? I did read your blog post. But that didn't clear this up for me.

“These interest payments are profits made by the ECB that will have to be returned to the national central banks, which will return these to the national treasuries. If we use the same equity shares to return the interest payments and if the interest rates on these national bonds are the same, the ECB will return exactly the same amount of interest it has received from the national treasuries back to the same treasuries.”

That is not correct because the interest payments aren’t the profits. They’re only the profits if you assume that the interest rate paid on excess reserves and similar liabilities is set at zero permanently (also omits operating cost, but put that aside).

The issue is interest rate risk.

For example, the implicit Fed “model” for QE is that the Fed wants to exit QE eventually and that it wants to start to exit after it starts raising interest rates. And the expected exit time period is the better part of a decade I think. So that is the interest rate risk that is inherent when considering the life cycle of QE.

Consider that sort of approach for the ECB where they eventually buy several trillion for example. Suppose they buy bonds at 2 per cent. And somebody defaults 5 years from now. And suppose the interest rate the ECB pays on reserves and similar deposits goes up to 2 per cent by then. Whatever they’re paying out to the capital holders in profit at that time – it won’t be 2 per cent. It will be less. So the point is that the defaulting sovereign will be leaving behind a worthless asset on the ECB balance sheet (which is the same as negative equity at the margin), and that position will still be funded by the reserves that were created when it was bought – which are now paying 2 per cent. So the ECB and the rest of the sovereign group is left holding that cost even though profit remittances to the defaulting member have stopped. Stopping the defaulter from receiving distributions doesn’t solve the problem. There is still a fiscal transfer in effect from the defaulter, put back to the remaining members that is equal more or less to the interest being paid on reserves supporting that worthless asset. That is now a net cost that they will bear.

I'm with Professor Farmer, here. Central Banks don't exist to safeguard their balance sheets. They exist to stabilize the economy. If they suffer grave losses in the process, that's okay. Their goals should be full employment and prices that do not fluctuate wildly.

OK, but that's not the point of my post or of De Grauwe's original assertion.

The point is about whether there are fiscal transfers when a sovereign defaults on bonds held by the ECB.

That is completely independent of the question of whether the ECB should recapitalize or run negative equity when faced with losses.

I spent about .01 per cent of my post on the second issue, including an opinion about the psychological relationship between accounting rigor and economic analysis - in the particular case of a currency union central bank. I suggested that recapitalization would be the norm from an operational perspective - not that it is essential from either an operational or an economic perspective. The word I used was "appropriate" in the sense that it reinforces the fact that there are real fiscal transfers - costs incurred by the non-defaulters. Consider it dramatic emphasis.

So the question of fiscal transfers is quite orthogonal to the operational and accounting choice of negative equity or recapitalization. It is a straw man point relative to the main topic here.

As Professor Farmer says in the blog post, "The net worth of the ECB may take a temporary hit, but that shouldn't bother European taxpayers, least of all the Germans." Isn't that clear that he agrees that the default immediately results in a fiscal transfer from the central bank to the bond issuer? You seem stuck on this point that no one disputes. The point of the blog post is that central bank policy should not care about this. The central bank has different goals not at all served by worrying about such fiscal transfers. In a depressed economy at ZLB recapitalization is easy. Create more money out of thin air. If inflation starts to become a problem, no need to despair. Raise rates and operate with negative equity. I think it is your tangent that is the straw man, here.

My first comment was a link to my critique of De Grauwe’s post. The premise there is that there were no fiscal transfers under his proposed treatment. I dispute that. That’s what my post was about.

I have not critiqued Professor Farmer’s post yet, and don’t feel the urgency to do so. That said, there are connections between the two, but I have not parsed them out. So I have not actually disagreed with the Professor’s post so far.

Now ...

For example, I’m fine with the example of the Fed buying stocks – insofar as the topic in question is concerned – because the issue of fiscal transfer is entirely different for the Fed than for the ECB. The existence of the US Treasury pretty much neutralizes the issue in that comparative context.

But I disagree with the following excerpt from the Professor's post, as it seems to be a similar analysis as De Grauwe’s:

“The interest payments on ECB assets are returned to national governments in proportion to a formula that weights each country by its relative size. As Paul DeGrauwe pointed out recently in a VoxEU post, as long as the ECB sticks to this formula when it buys sovereign debt, the only people to suffer from an Italian default will be private holders of Italian bonds. The net worth of the ECB may take a temporary hit, but that shouldn't bother European taxpayers, least of all the Germans.”

And my post and my additional comments are intended to explain why I disagree with it.

The Central Banks are acting as if they were the owners of a 'company town'.

They are making the correct assumption that they have broad control over the economy in their currency jurisdiction. Acting as a controlling body, they are allocating resources between economic sectors and between competing currencies.